Chicago Booth Review Podcast Will Alternative Investments Underperform?

Joe Pagliari: So just to give you a real estate example, think about a grocery anchored shopping center that's well built, well leased, well located. The grocers either are a regionally or nationally recognized brand, and that investment is viewed as relatively safe as compared to the other two strategies.

Hal Weitzman: In recent decades, US pension and endowment funds have increasingly allocated funds to alternative investments such as private equity and venture capital. Will those investments pay off? Welcome to the Chicago Booth Review Podcast, where we bring you groundbreaking insights in a clear and straightforward way.

I'm Hal Weitzman, and today I'm talking with Chicago Booth's Joe Pagliari about his research on real estate private equity funds. He's concerned that these riskier investments may not generate the returns that they expected to earn.

Joe Pagliari, welcome back to the Chicago Booth Review Podcast.

Joe Pagliari: Thank you.

Hal Weitzman: We are here to talk about alternative investments, which has been a huge trend in finance generally over the past, I guess, five years in particular. All sorts of pension funds, retirement funds. Probably many of our listeners' retirement funds are invested, or some of their investments are in alternatives, whether they know it or not. And endowment funds like here at the University of Chicago and Harvard. So give us a brief overview of this debate and where we are right now, please.

Joe Pagliari: So it really started with a gentleman by the name of David Swensen at the Yale Endowment in the mid '80s. And his view of the world was we're an endowment fund where we have nearly an infinite investment horizon, and therefore we can invest in private market assets that will pay us an illiquidity premium. In other words, as we get out of the public markets and into the private markets, the private markets are less liquid and we should be compensated for that.

Prior to that, most institutions ran some version of what we call the 60/40, 70/30 portfolio. 60% common stocks, 40% bonds or thereabouts. So Swensen's kind of revolutionary view was, "Hey, let's allocate a portion of our portfolio to these private market assets, whether they be LBOs, venture capital, real estate, whatever they might be, and let's pick up that extra return due to the illiquidity of the private markets, because we as an institution can withstand the lack of liquidity."

Hal Weitzman: Okay. But let's just dig in for a second because you've mentioned very quickly. So it's things like private equity, like venture capital.

Joe Pagliari: Leveraged buyouts, private equity, real estate, those kinds of things that have been very popular, to your earlier point, with regard to institutional investors.

So Swensen and Yale was very successful. There's a lot of imitation. Once you achieve some level of success, a lot of copycatting. And a number of institutions have decided to also tilt their portfolios towards these private market or alternative investments, or alts for short. And in many instances, there's been too much capital, chasing too few deals. And so there's been some disappointment with regard to this excess return. In other words, how much more did we get compensated by having taken our money out of liquid assets and putting them into illiquid assets?

So as an aside, Steve Kaplan here at Booth has taken a very deep and rigorous look at this. And I think Steve would characterize that spread as coming down over time. Richard Ennis, the former editor of the Financial Analyst Journal, amongst other things, has examined the endowment funds and finds that as endowment funds increase their allocations to alternative investments, their performance relative to the 60/40 benchmark actually declines. So there's kind of a reckoning of sorts that maybe the bloom is fading with regard to private equity generally.

On the other hand, another thing has kind of manifested itself over the last 10 or so years, which is these private market assets don't display the same kind of volatility as the public market assets because the valuations aren't marked to market on a daily or hourly or minute by minute basis like they are in the private equity world. So the reported volatility of returns with regard to the alternatives, including real estate, are, in most people's view, understated. So when we talk about sharp ratios and all the rest, risk adjusted rates of return, using just the reported valuations, many people push back on those.

Cliff Asness, a famous Booth alum at AQR, coined the phrase volatility laundering with regard to these private market assets and the fact that many institutional investors actually like the fact that there's not the same level of volatility as found in the public markets. And it's a way, particularly during a overall downturn, you can think about the GFC, you can think about COVID, you can think about the Fed's recent rise in interest rates, the fact that there are slow moving marks with regard to the private market assets, when I say marks, I mean mark to market, kind of provides a little bit of balance, a little bit of stability to their portfolio that is perceived to be a benefit.

Hal Weitzman: Right. But as you say, it's because it's opaque and we don't really know what it's-

Joe Pagliari: Right, right.

Hal Weitzman: So we know our stock portfolio is down any one day. We don't know anything what's going on in these alternatives.

Joe Pagliari: Yeah. You can think about the mental image of the ostrich putting its head in the sand.

Hal Weitzman: Right. So I mean, we also don't necessarily, as you say, we don't necessarily know what anything is worth until it's sold. And we've actually recorded an episode with Steve Kaplan, encourage people to go back and listen to that if they want to hear more about that.

Joe Pagliari: And to your point, some of these assets are difficult to value. It's very imprecise to know what the value of something is today if it hasn't been sold in these kind of unusual investment strategies.

Hal Weitzman: Okay. And obviously you're a real estate expert, so your research is about real estate, private equity funds specifically, and you're going to have to define some of these terms for us. So those of us who haven't sat through your MBA class, value added funds, opportunistic strategies. I want to hear what those are. And then you talk about core value added opportunistic. So just define those three terms. What are core value added and opportunistic real estate investments?

Joe Pagliari: Yeah. So you can think about core as, amongst those three alternatives, that is the low risk, low return segment. So just to give you a real estate example, think about a grocery anchored shopping center that's well built, well leased, well located. The grocers either are regionally or nationally recognized brand, and that investment is viewed as relatively safe as compared to the other two strategies.

So value add is just tweaking the risk return profile a bit by saying, "Rather than having a stabilized shopping center, maybe we're going to buy a shopping center that is in some sense dilapidated and the tenants don't any longer kind of match the trade area." So we're going to have to re-skin the facade, we're going to have to remove the existing tenants, bring in new tenants. All that takes time, money, and risk. So the value add deals have a slightly higher expected rate of return, I shouldn't say slightly, have a higher expected rate of return, and they have more risk.

Opportunistic is on the far end of the risk return spectrum. Just to continue with the shopping center analogy, that might be a ground-up development. I have no tenants in place, there's no building. All I have is a piece of dirt, and I'm going to build this shopping center and hope that it leases up at the rates I think, and I'm going to create some value for my investors.

So you can kind of think about those three strategies as hopefully, at least in theory, aligning themselves in risk return space. So low risk, low return is core, high risk, high return is opportunistic, and value add sits in the middle.

Hal Weitzman: Now, since private equity is expensive to get into, high fees, they generally want high returns, does that mean that most of what they're looking at is opportunistic?

Joe Pagliari: It's some combination of value add and opportunistic. And actually the value add funds are probably, in terms of number, there are more than there are opportunistic funds. In terms of dollars, it's probably pretty close.

The other side of this question is what about the fees? For a core fund, the fees average around 100 basis points a year. For a value add fund, they average around 300 basis points a year. And for an opportunistic fund, they average about 400 basis points. So when I talk about the fees, it's both the base fees and the promote or the carried interest that combine for those numbers.

I should say in passing that very few core funds have a promote. You only really find a promote or a carry in a value add or opportunistic fund.

Hal Weitzman: Could you just remind us what a promote ... What does that mean?

Joe Pagliari: So a promote is a preferential payment, a special allocation of profits over a preferred return to the general partner of the fund, the investment manager. So a typical structure is I'll pay my investing partners, the limited partners, an 8% preferred return. Any profits above that 8% return are going to be split typically 80% to the limited partners, 20% to the general partners, and that 20% is disproportionate to whatever capital that general partner contributed.

Hal Weitzman: Okay.

Joe Pagliari: It's an incentive mechanism. It goes back to the whole principal agent issue about how do I motivate an agent to expend costly effort when I can't monitor their effort.

Hal Weitzman: So you talked about these big funds, pension funds, everything, and retirement funds that we all have some of our retirement in, and that more and more has been going, over time, to private equity. And some of that is finding its way into these deals that you're talking about. And your research suggests that the returns on that haven't been at what they should be. And as you say, maybe not even as good as it would've been just leaving it in the 60/40 distribution.

Joe Pagliari: So again, I'll just go back to theoretically, core is the low risk, low return strategy, opportunistic, the high risk, high return strategy, and value add in the middle. When you adjust for fees, which are the differentials we talked about before, and you adjust for risk, what you find is in the real estate space, that, on average, the value add and the opportunistic funds have underperformed core with leverage by about 300 basis points per year. So when you take 300 basis points per year on the size of the market, it's a huge amount of dollars and some cents being wasted.

Now, I just want to reiterate that when I talk about 300 basis points on average, that doesn't mean that every private equity fund generates 300 basis points of negative alpha. Some are better, some are worse. But 300 basis points is a big number to jump over on average.

Hal Weitzman: Okay. So those that have overallocated in the more risky investments have not seen the returns?

Joe Pagliari: Have not seen the commensurate returns. And part of the issue here is a lot of the public sector pension plans have underfunded pension liabilities, and, because of that, the relatively low returns of core, even though on a risk adjusted basis they're better, are not attractive relative to the underlying actuarial return assumptions baked into their pension fund liability calculations. So in some sense, the default is let's move towards higher risk, higher return strategies, swing for the fences, gambling for redemption, taking the pension fund to the casino-

Hal Weitzman: They like the guy with $5 who goes to the casino rather than putting in the bank.

Joe Pagliari: Right. Exactly right. Right.

Hal Weitzman: Okay. So your conclusion is that these non-core funds have not worked out for investors. And in fact, they would've been better off adding leverage, as you say, to their leverage, so would say to their-

Joe Pagliari: Gearing as they say in other parts-

Hal Weitzman: Gearing.

Joe Pagliari: ... other parts of the world.

Hal Weitzman: Good old fashioned term, to their core investments.

Joe Pagliari: Right. Yeah.

Hal Weitzman: So how would they have done that, and what difference would it have made to their returns?

Joe Pagliari: So let me just back up one step. It's somewhat paradoxical that the core funds have relatively low leverage, call it 25% on average. The value add and the opportunistic funds have leverage ratios are anywhere from 65 to 85%.

Hal Weitzman: Oh, wow.

Joe Pagliari: So they're very heavily levered or geared investments. And I think a number of investors don't fully appreciate, limited partners don't appreciate the fact that leverage increases the expected rate of return and increases the volatility of the outcomes. And let's just go back to this notion of the promote or the carry. The expected value of the promote is, you can think about it as an option, right? The general partner is getting paid a contingent interest on the future profitability of the fund. Like any option, the value of the option goes up as the volatility of the underlying instrument goes up. So the more leverage I place on these assets, I'm both increasing the expected rate of return and I'm increasing the volatility. I've increased the expected value of the promote. And I think that's where some investors have fallen a little bit short in understanding the ramifications of trying to solve this principal agent problem that we talked about in the very beginning.

Hal Weitzman: If you're enjoying this podcast, there's another University of Chicago Podcast Network show that you should check out. It's called Nine Questions. Join Professor Eric Oliver as he poses the nine most essential questions for knowing yourself to some of humanity's wisest, the most interesting people. Nine Questions with Eric Oliver, part of the University of Chicago Podcast Network.

Joe Pagliari, in the first half, we talked about real estate, private equity funds, and alts, alternative investments, and how they have disappointed, particularly the more risky ones. Have big investors changed their behavior as a result? Have they caught up to the fact that this is happening, or are they still allocating as much as ever?

Joe Pagliari: So far, very few funds have sort of caught on to this, right? And so I think there's several issues at play. Talked a little bit about it before. Underfunded public sector pension plans need to have, at least on paper, high expected rates of returns, and I don't need to get into the weeds of these calculations, but as a way to reduce the pension liability. So there's that. There's also the incentives of not only the general partners, but the limited partners. A lot of people on the staffs of these various pension plans and endowment funds get paid a bonus, a significant bonus, if they beat certain benchmarks. If the benchmarks are set low, those bonuses are more easily paid, right? So if we ignore risk, and ignoring risk is maybe a harsh statement, but it's difficult to quantify risk in these private market assets that don't trade frequently.

So what you have is consultants, staff, in some sense the board of directors, of these various pension plans and endowment funds looking to beat relatively low set benchmarks. Richard Ennis, again, describes it as chasing slow rabbits as a way to generate bonuses for the staff to have the [inaudible 00:16:09].

Hal Weitzman: So just explain that in a second. So where do these benchmarks come from? Is that the expected returns you're going to get?

Joe Pagliari: Yeah. So there are various private market real estate benchmarks. NCREIF is one well-known entity. It's actually here in Chicago. Stands for the National Council of Real Estate Investment Fiduciaries. They publish quarterly the performance of institutional quality assets. Again, these have relatively low leverage on them. And so to compare the high risk, high return, value added and opportunistic funds to these low levered core strategies is a little bit of a risk return mismatch. But in doing so, you create these bonuses for people up and down kind of the food chain.

And just to go off for a second, off the topic, it's kind of difficult to think about who is there to voice concerns about this. The typical taxpayer doesn't really understand all the minutiae with regard to pension fund liabilities, but the taxpayer is ultimately backstopping these public sector pension plans should they fail.

And so if you want to think about it in a legal setting, we talk about who has standing, who's been damaged. That damage really hasn't occurred yet, but ultimately if these things blow up, it's going to fall at the footsteps of the taxpayers.

Hal Weitzman: What would it take for them to blow up?

Joe Pagliari: They don't have enough money to pay the benefits promised to the retirees.

Hal Weitzman: Okay. Yeah. But given the opacity that we talked about earlier, we could already be at that point.

Joe Pagliari: We could. And some pension plans and endowment funds are getting close to that point, and they're very disturbed, the limited partners are very disturbed, the institutional investors are very disturbed about the fact that distributions from these private market vehicles has slowed dramatically in the last few years, and therefore they, these institutional investors, aren't as able to make their pension payments as they were before.

Hal Weitzman: But as you say, does that then put them into this spiral where they now have to be even more risky?

Joe Pagliari: Right. So it's kind of like the dog chasing its tail, right? And that's kind of the problem. And my concern is that, at some point, it may blow up.

Hal Weitzman: So the other explanation you had, apart from the incentives, was something to do with mental accounting. Tell us a bit more about that.

Joe Pagliari: Yeah. So our Richard Thaler has a very nice example of mental accounting. He talks about people think about their salaries as one kind of financial bucket and their year-end bonuses or their bonuses in general as part of another bucket. And the way they spend money out of those two buckets differs, even though cash is cash. I would argue something similar is going on with regard to institutional investors. They think about core investments in one bucket and they lump value added and opportunistic funds in another non-core bucket, and they evaluate them differently.

So I think part of what's going on, it's not the whole explanation, but I think part of what's going on is just this mental accounting problem. That for so long we've treated these two strategies, core and non-core, as very different animals when we should look at them in a more integrated kind of-

Hal Weitzman: In other words, people don't think they're interchangeable or they don't compare them.

Joe Pagliari: Yes. Correct. Right. Yeah. They're not interchangeable, which I'll just go back to the leverage thing as one example. The fact that we have low leverage on our safer assets and high leverage on our risky assets seems to me to be completely backwards. Pension plans, endowment funds would save a lot of money just by leveraging up the safe assets and deleveraging the riskier assets, just from the standpoint of what does the lender charge you as an interest rate to make you a loan on a safe asset versus a risky asset?

Hal Weitzman: But what's the mental accounting part that you were talking about? Is it that, it's my lottery ticket, so it might hit big at some point and pay off. And so if there's a slight downside, I'm not too concerned about it.

Joe Pagliari: I think it's less the lottery idea, though that's part of it, and more the idea that we're underfunded and we need to kind of swing big in order to make up for the fact that we're underfunded, and therefore we're going to allocate more and more of our dollars to these alternative investments.

Hal Weitzman: If these non-core funds, these alternative investments that are riskier and as you say, have more leverage and-

Joe Pagliari: And higher fees.

Hal Weitzman: ... higher fees, of course, so if these are underperforming on average, are the managers overpaying for the assets or are they mismanaging them?

Joe Pagliari: So I think the managers are overpaying. I would say, again, too much money chasing too few deals. I think most of these investment managers are staffed by brilliant, hardworking, ethical people trying to maximize the value of the assets. But on the front end, they've overpaid for the opportunity, you end up with disappointing results.

Hal Weitzman: Okay. And you've seen that the returns for these opportunistic funds fell, or sorry, they looked suspicious rather, during and immediately after the crisis 2007 to '09-ish and think it looked suspicious. Tell us more about that.

Joe Pagliari: Yeah. So this is kind of the standard criticism of the slow moving marks of private equity in general. During the financial crisis, as one example, where asset values in the public markets were cratering, reported asset values in the private market were basically standing still. No one really believed those marks, but that was the reporting. And in some sense, those stale or slow moving marks get baked into the calculations of return performance, and hence the fact that volatility is understated and things like the Sharpe ratio are overstated.

Hal Weitzman: Okay. So this is all painting a pretty dim picture, particularly for those of us who have our money in retirement funds and are concerned about the growth in alternatives.

Joe Pagliari: And to add to your concerns, the current administration is considering opening up private equity to individual investors.

Hal Weitzman: Right.

Joe Pagliari: Right? So that's another whole-

Hal Weitzman: And the interesting thing about it is that economists talk about this as kind of in terms of the system, it's risk-free. It's not risky to the system in general because those who invested would just eat the losses, but that's us.

Joe Pagliari: Yeah, right.

Hal Weitzman: So if we were our own money manager, managing our own money, what would we do? What should these institutional investors do? Should they renegotiate the fees, which as you say are very high? Should they just abandon this whole alternative investment strategy?

Joe Pagliari: If they could renegotiate the fees, which is difficult to do from the standpoint of an existing investment management contract, that would be a good thing. If they could negotiate the fees lower in future investments, that would also be a good thing. But I think fundamentally the problem is, right now, there's too much non-core money chasing too few deals, and so therefore the returns are going to be disappointing. The alternative is to think about core with more leverage, as the paper suggests.

The other thing we haven't talked about is the real estate world is kind of unique in the sense that there are two separate markets operating side by side. That is to say there's the public real estate investment trust market, and then there's this gigantic private market. There's a huge amount of overlap between the two. So if you really want real estate exposure in your portfolio, you could think about very easily buying a basket of real estate investment trusts. If you believe in market efficiency, you would say that in the public market, the REITs are effectively fairly priced. Fees, costs tend to be very low. You eliminate all the idiosyncratic risk of having a fairly small band or portfolio of properties. And you have liquidity.

So there are alternatives. It doesn't have to be a decision to invest in the alternatives. But once you invest your real estate money in REITs, now you see the volatility. So back to Asness's volatility laundering, that's not possible in the public REIT space, and I think that's part of the impediment to these institutional investors allocating more to public REITs.

Hal Weitzman: So if you put it in REITs, just don't check your portfolio very often.

Joe Pagliari: Yeah. Or just live with the volatility. Recognize that it's like any other publicly traded stock, it's going to go up, it's going to go down. If you don't have any immediate liquidity needs, it doesn't really matter all that much.

Hal Weitzman: Joe Pagliari, thank you so much for coming back-

Joe Pagliari: Thank you.

Hal Weitzman: ... on the Chicago Booth Review Podcast.

Joe Pagliari: Appreciate it. Great to be with you.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis, and insights, visit our website, chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research.

This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe and please do leave us a five-star review.

Until next time, I'm Hal Weitzman. Thanks for listening.